Greece -- 2005 Article IV Consultation, Conclusions of the IMF Mission
September 19, 2005
The Greek economy has been growing robustly for some time, sustained on the demand side by the sharp decline in interest rates due to the adoption of the euro, financial market liberalization and the associated rapid growth of private sector credit; and on the supply side by strong capital formation, immigration, and productivity gains. Real GDP growth is slowing somewhat this year, reflecting a sharp fall in investment due to the end of expenditures for the Olympic games and high oil prices. On the other hand, household consumption spending is being supported by further credit growth and exports boosted by continued strength in shipping and a resurgence in tourism. In 2006, growth is likely to moderate slightly again. Although investment is set to rebound, demand will be weakened by the full impact of oil prices, further erosion of international competitiveness, and the gradual waning of the beneficial effects of euro entry.
Against this backdrop, the authorities have introduced policy initiatives in a number of areas. Most importantly, the 2005 budget aims for a significant cut in the deficit. In addition, reforms have been implemented to address the pension difficulties faced by some banks, improve product markets and the business climate, increase labor market flexibility, and promote infrastructure investment. At the same time, a broad agenda remains: fiscal consolidation must continue for a number of years, the need to act on pension reform is becoming increasingly pressing, and further structural reforms are required in product and labor markets and in the public sector. If these challenges are met, Greece will be well placed to catch up to the productivity and income levels of western Europe, and benefit from the economic development of neighboring countries.
The top policy priority is to reduce the fiscal deficit. Despite strong economic growth and low interest rates, the general government deficit rose relentlessly during the past four years and, although final estimates are still not available, significantly exceeded 6 percent of GDP in 2004. Rapid growth in real primary spending (even excluding Olympics spending) underlies this deterioration. As a result of this poor fiscal performance, little progress has been made in reducing the very high level of public debt in relation to GDP.
The authorities' objective of reducing the general government deficit below 3 percent of GDP by 2006 is therefore welcome. The deficit will fall substantially this year, and significant further measures will be needed in the 2006 budget. The growth of primary spending is being held well below the high levels of recent years by curtailing increases in the public sector wage bill and by using the end of Olympics spending to cut the deficit rather than finance other programs. However, the consolidation effort has weaknesses. Most prominent is the planned securitization of overdue taxes, estimated to bring in revenue of about 1 percent of GDP in 2005, and again in 2006. This is a temporary measure that does not improve the underlying budget position. Also, the authorities have relied on across-the-board reductions in public sector wage and employment growth, rather than establishing a plan to rationalize spending. An issue that has arisen this year are tax receipts, principally from the VAT, that have fallen well short of budget forecasts because of increased evasion. The success of measures to stem this shortfall, which are already underway, will be critical to meet consolidation goals.
The sustained effort needed to restore the health of the public finances needs to focus on containing primary expenditures enough to achieve the deficit objective while making room for needed investments and tax cuts. This fiscal adjustment should be conceived in a medium-term context that allocates scarce public resources according to well defined policy priorities, and we urge the authorities to develop and adopt such a multi-year budget strategy. The strategy should aim for structural budget balance by 2010, to prepare for the costs of population aging, which will begin to climb in the next decade. Beyond 2010, budget surpluses may be appropriate to pay down the public debt faster and free up more funds for rising pension payments.
Sustained consolidation will also have to be underpinned by deep reforms to expenditure management and tax administration. Successful implementation will require guidance by high level task forces, which are now being established, and strong political backing. Important priorities for expenditure management are to focus the budget process on programs (which will be key to the prioritization of spending), streamline spending control, improve auditing, and evaluate program outcomes relative to budgeted objectives. To promote the focus on program priorities, the ordinary and investment budgets should be integrated. Reform of tax administration should be centered on developing a modern system of self assessment supported by risk-based enforcement mechanisms. A number of other measures are also of high importance, including bimonthly filing of VAT returns, improved audit procedures, and stronger measures to collect tax arrears. The tradition of tax amnesties, which undermine compliance, should be abandoned. Progress on both the expenditure and tax fronts will require improved information management and systems, and some measures have already been taken.
The long-term fiscal outlook is dominated by the fiscal costs of population aging, principally rising pension outlays, but also increasing health costs. On the most recent projections available, which are out of date, these costs will rise sharply after 2010 and, in the absence of corrective measures, will eventually result in the explosive growth of the public debt. Some public debate on pension reform has already started, sparked in part by the reform to banking sector pensions, and the government has referred the issue to the Economic and Social Council. However, a highly visible and comprehensive social discussion should begin immediately to explore the key issues and possible solutions, with a view to early implementation of urgently needed concrete reforms. In this regard, the authorities should quickly update the projections of the fiscal costs of aging and closely monitor developments, including by bringing the National Actuarial Authority up to full strength. Health-care reform is also required. Initiatives to improve the procurement process are a welcome step forward, but additional measures will be needed to control costs while ensuring a high level of service.
The Greek financial system has evolved rapidly in recent years, reflecting the privatization of public sector banks, deregulation, and economic integration with the EU. Commercial banks have benefited most from these developments and have expanded rapidly. Capital markets and insurance companies, by contrast, have not gained proportionately and remain small by European standards.
Commercial banks are well capitalized and profitable with adequate liquidity. Their strong position reflects the rapid growth of credit to new clients—particularly households and enterprises such as SMEs—and expansion into the relatively under-banked regions of southeast Europe. However, these developments have also exposed banks to unknown risks, because neither they nor their new clients have had experience in managing the effects of sharp interest rate hikes or economic slowdowns. Some pressure has already appeared, as nonperforming loans have begun to rise. Commercial banks also face structural challenges, the most important of which include (i) legal and institutional impediments to strengthening competitiveness, (ii) increasingly costly funding sources, as deposit growth fails to keep up with lending, (iii) strengthening their risk management capacity, and (iv) introduction of the new International Financial Reporting Standards (IFRS), which enhances transparency but may result in a one-time capital charge.
Banking supervision has effectively responded to the challenges of this new environment. The authorities tightened the prudential framework for the banking system and improved both on-site and off-site supervision to analyze risk. Capital market regulation has likewise been strengthened and the Hellenic Capital Markets Commission is playing an increasing role in the oversight and regulation of capital markets. However, insurance sector supervision and regulation are weak, hindering the assessment and control of risks.
During the first half of 2005, Greece participated in the Financial System Assessment Program (FSAP) to review the conditions of the financial sector. The FSAP concluded that there are no systemic threats to the financial sector but urged action on medium term vulnerabilities. The Bank of Greece should continue to monitor the rapid expansion of credit by Greek banks, in particular the growth of nonperforming loans. The capital markets supervisor is gaining credibility and effectiveness, but will face important regulatory challenges as IFRS are implemented. Making the new insurance supervisor operational and fully resourced as quickly as possible is an important priority, especially since banks are expanding into the insurance sector. Pension supervision should be strengthened in anticipation of the increasing importance of second pillar schemes. Across sectors, procedures should be established to ensure effective cooperation among supervisory agencies and strengthen legal protection of supervisors.
Improving the productivity and competitiveness of the Greek economy, including achieving Lisbon objectives as laid out in the draft National Reform Program, will be vital to raising living standards to those in western Europe and meeting future pension obligations. This will involve developing and implementing a medium-term program of structural reform to strengthen the performance of product and labor markets and the public sector, and to ensure adequate infrastructure investment.
Regarding product markets and improving the business climate, the authorities have recently put in place a number of welcome initiatives which should be built on in the years to come. These include the new competition law and the strengthening of the Competition Authority, the extension of shop opening hours, and the cut in the corporate income tax. A key aspect of a better business climate is reducing the administrative burden that government places on firms. The implementation of the reforms to tax administration mentioned above would reduce uncertainties associated with the current system. Simplification of business licensing procedures, envisaged now for the industrial sector and later for the commercial sector, should be pursued vigorously. We also welcome the work now underway to overhaul bankruptcy legislation. The authorities are moving ahead with the liberalization of electricity and gas markets, in accordance with EU directives, and we encourage them to accelerate the timetable where feasible. The new investment law will help to promote regional development, but care should be taken to ensure its budgetary cost is contained.
The authorities' plans to reform state-owned enterprises (SOEs) are also welcome. The elimination of tenure and the introduction of private sector pay scales for new OTE employees is an important step, and should be extended to other SOEs. The planned introduction of IFRS, strengthened corporate governance, and more thorough oversight of business plans will, if successful, improve the performance of SOEs. This, in turn, would contribute to fiscal adjustment by reducing the need for subsidies and loan guarantees. However, putting SOEs on a more commercial footing should in many cases be considered a first step toward eventual privatization. Full privatization should be the rule, since its purpose is not only, or even primarily, to reduce public debt, but rather to increase economic efficiency.
Labor markets are also undergoing important reforms, although the pace remains relatively slow. The recent easing of overtime restrictions will provide welcome flexibility and thereby promote hiring. Reforms to the immigration law should help to bring workers into the formal economy, providing the government with revenues from taxes and social security contributions and immigrants with social protection. Labor markets should be further liberalized, however. Relaxation of strong employment protection legislation would stimulate hiring. In many cases, especially in sectors under severe economic pressure, high minimum wages negotiated at the central level are inappropriate, resulting in job losses or a shift to the underground economy. A mechanism allowing opting-out of aspects of the central agreements, which are negotiated by the social partners but extended to the economy as a whole, would provide needed flexibility. The next central agreement is about to be renegotiated, probably for two years. With regard to the wage settlement, the social partners should bear in mind the steady erosion of Greece's international competitiveness that has taken place as prices and labor costs have outpaced those in the rest of the euro area. Stemming this deterioration will require wage increases that are no more than the sum of productivity growth in Greece and inflation in the euro area. Finally, the significant labor-market bottlenecks and mismatches would be mitigated by raising educational standards and promoting closer collaboration between educational institutions and employers.
The new public-private partnership (PPP) law is welcome. PPPs, if properly implemented, hold the promise of increasing the efficiency of public investment projects to the benefit of both the budget and the economy as a whole. In implementing the new law, it will be important to assure full transparency (including the budgetary implications of the entire life of each project), as well as coherence with the broader budgetary process and public investment priorities. Preferably, this would be done through a comprehensive addendum to the budget. Finally, large investment projects should be included under the new PPP framework, because the need for careful project selection and transparency apply as much, if not more, to them.
The need to further strengthen economic data remains. In particular, better estimates of the quarterly national accounts are important for up to date assessments of the economy, and we note the efforts underway in this area. Publishing comprehensive financing-side data for the general government is essential for full analysis of fiscal developments. More timely banking system data would improve transparency and enhance market discipline. Finally, the intention of the National Statistical Service to adopt the new EU Statistics Code of Practice is welcome, and consideration should be given to granting it full formal independence.
We welcome the increase of official development assistance in recent years, to 0.3 percent of GNI in 2005, and urge further progress toward the UN target of 0.7 percent of GNI.
Athens, September 19, 2005